Making Pro Formas Perform

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Executive Summary

Reprint: F0310D

Regulators are trying to clear up the muddle created by earnings-report adjustments called “pro formas” that companies issue. Constraining such reporting, as the regulators seem bent on doing, isn’t the solution. Firms should increase alternative reporting—and fully account for their accounting.

Companies claim that earnings reports based on generally accepted accounting principles distort performance. Their remedy is to counter with idiosyncratic adjustments to GAAP earnings, called pro formas. Analysts similarly modify earnings reports, adding their own estimated and actual earnings metrics to the mix. We say, the more the better—with one proviso.

The problem with these customized reports is that they’re opaque. In reporting Microsoft’s earnings, for example, one analyst concluded that the company’s actual earnings per share figure was more than 4,000% greater than the GAAP number. To reach this figure, the analyst had ignored Microsoft’s investment losses of $2.7 billion yet included the company’s interest income of $825 million. Why? No explanation.

Skewed Performance

To find out how companies’ and analysts’ adjustments to GAAP earnings vary, we analyzed quarterly earnings reports for the Dow 30 in 2001. Among this select group of firms, we found that earnings reports skewed in systematic ways. Companies’ pro forma earnings deviated the most from bottom-line GAAP earnings. For all firms and in all quarters, pro forma earnings averaged 195% higher than fully diluted GAAP earnings per share. Analysts’ actual earnings (another pro forma variation) averaged 120% higher, and S&P core earnings (S&P’s version of pro forma) averaged 18% to 19% above diluted GAAP earnings per share. (See the chart “How Earnings Measures Skew Performance.”) Only one earnings measure was lower: clean surplus earnings, which is the most inclusive measure of a company’s performance, because it includes several volatile items that even GAAP allows firms to omit.

How Earnings Measures Skew Performance

A few outliers significantly influenced these averages. Microsoft’s fourth-quarter pro forma earnings, for instance, were more than 5,000% higher than GAAP earnings (55 cents versus one cent). To remove distortions caused by outliers, we ranked each company’s earnings measures from lowest to highest. Firms’ pro forma earnings were never the lowest of the earnings measures, whereas clean surplus was more than a quarter of the time. Any way you slice it, pro forma measures consistently yield the most upbeat earnings assessment.

Any way you slice it, pro forma measures consistently yield the most upbeat earnings assessment.

We also calculated the variance of each earnings measure. Variance indicates how volatile the earnings measure is. Companies prefer low-variance earnings measures because they suggest low operating risk. Therefore, one might expect that pro formas eliminate some volatility—and indeed they do.

The regulatory response to this accounting muddle is to restrict companies’ non-GAAP disclosures. The Securities and Exchange Commission now requires companies to show which components of their GAAP earnings are excluded in the derivation of pro forma earnings. And the Financial Accounting Standards Board and the International Accounting Standards Board are also considering guidelines that could further constrain companies’ future pro forma reporting.

But restricting reporting isn’t the solution. If pro formas and analysts’ reports address GAAP deficiencies, as claimed, then hewing more closely to GAAP won’t necessarily reveal anything. Instead, firms should increase their alternative reporting—provided they fully account for their accounting. For example, some companies fault GAAP for expensing R&D and omitting the value of human capital. If organizations were encouraged to provide alternative financial statements that explained their adjustments for these and other alleged deficiencies, we could then expect greater, not reduced, transparency. This approach would shift the emphasis of a firm’s earnings reports from point estimates to economics—how the company actually creates, or loses, value for shareholders.

Firms should increase their alternative reporting—provided they fully account for their accounting.

If a firm or analyst feels that GAAP-based measures distort performance, what could be more illuminating than a point-by-point defense of the adjustments? If such expanded reporting were required, it would force firms to disclose more economic reasoning (particularly with respect to the amounts, timing, and probability of future cash flows) and, at the same time, allow them to deviate as much as they like from GAAP. If the adjustments are legitimate, the explanations would reveal that, but if the data massaging is intended to deceive, the defense of the adjustments would surely reveal the charade.

A version of this article appeared in the October 2003 issue of Harvard Business Review.

Stephen Bryan is an associate professor of accounting at Wake Forest University’s Babcock Graduate School of Management.

Steven Lilien is the Weinstein Professor of Accountancy at Baruch College’s Zicklin School of Business in New York.